Contrasting Savings Calculations: Procurement vs The Business

Obviously as someone working in the eAuction space I am love learning how other people measure their savings. Here’s an interesting article on the subject from Next Level Purchasing:  http://nextlevelpurchasing.com/articles/calculating-cost-savings.html.

It points out the fact the executives like to see Procurement deliver year on year cost savings, but Procurement might be doing better to lock in longer term cost savings now. This presents a dilemma which Next Level articulate very well:

Imagine this situation:
* You are responsible for buying a certain item
* Last year, you bought 10,000 units of the item at $100 each
* This year, you’ve signed a 3-year contract with your supplier
* The contract price is $90 per unit of the item
* You will buy 10,000 units of the item in each year of the contract

[S]enior management expects to see a reduction in expenses from the previous year to the current year. So, in the scenario described, your expenses will not be reduced by $300,000 this year – they will only be reduced by $100,000 which is this year’s quantity multiplied by the difference in price.

Next Level take the very pragmatic view of:

One way is to negotiate a price that declines each year during the contract. For example, instead of starting at the $90 price, you would negotiate the price to be $95 in the first year, $90 in the second year, and $85 in the third. While the contract value is the same to the supplier, you’ll get to report savings in each year of the contract and senior management will recognize three years of year-over-year expense reductions.

This raises some very important points and shows what can happen when Procurement and The Business are not aligned fully in their objectives.

  • Procurement looks good because they have achieved a $5 decrease year on year for 3 years
  • The Business suffers because, although on average over the 3 years you are paying $90, in year one you are paying $5 more per piece. In effect The Business has to wait till year 3 to get the extra $5 back.

This has serious cash flow implications. If you go down this route then you have deprived the business of $50,000 in cash in year 1 that The Business could be using for investment in capital, marketing, etc.

On top of this, by the end of year 3 you have got to $85 a piece. So what then happens in years 4, 5 and 6? Given the fact that you are already on $85 a piece will you get a further cost saving? Or will you end up having to swallow a cost increase to $90? Will the fancy footwork you did to make yourself look good in years 2 and 3 just postpone the issue of how to continue presenting year on year savings to the business?

Now I know the situation that Charles describes happens all the time. And I know that keeping some savings in reserve is a tried and trusted procurement tactic. But this issue does point to a major disconnect between The Business and Procurement, if their interests go in opposite directions.

For procurement to become a true strategic partner to the business, this disconnect is what really needs to be addressed.

Hell, some procurement leaders I am aware of are even questioning the value of reporting savings, precisely because of issues such as this. Now that would be an impressive step: What do purchasing do apart from delivering savings and ordering paperclips? Procurement would really have to figure out another way of demonstrating value add.

In the meantime, while you are still working on your savings, take a leaf out of Steve Mallaband’s book.

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